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- 1. Equity Markets “It is usually agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of Stock Exchanges.” - John Maynard Keynes
- 2. Equity Markets Equity = ownership Shares representing part ownership of a business enterprise Exemplified by part ownership of early temporary business Rapid progression in India over last three decades Evolved into efficient avenues of raising capital Best performing asset class over the long term
- 3. Prominent Equity Markets Market capitalisation, $bn US 21,149 Japan 4,222 China 4,038 UK 3,603 Euronexta 3,037 India 2,966 Hong Kong 2,873 Canada 2,010 Germany 1,617 Switzerland 1,362 Australia 1,182 Brazil 1,152 Korea 1,146 OMX Nordic Exchangeb 1,077 Spain 983
- 5. Equity Markets Main function is raising capital for productive purposes •Loans •Bonds •Securitisation •Venture Capital •Equity Fund raising options
- 6. Types of Equity Common stock or ordinary shares • Voting rights Preferred stock • Cumulative • Non-cumulative Convertible preferred stock • Converted to common stock Warrants • Rights issue
- 7. Equity Issuance Issuing shares • Initial ownership with individuals / VCs • Regulatory requirements (time / profit) Flotation • Selling shares to public • Leverage new opportunities • Spin-offs • Exit option for founders / VCs • Compensate employees • Divestment process of Govt.
- 8. Equity Issuance Private offering • Placement with private investors • Hedge funds; HNIs • Requires lower disclosures • Lock-in may be prescribed Secondary offering • FPOs • Issued by company or large investors • Additional shares issued to increase capital • Leads to dilution
- 9. FLOTATION PROCESS Registration with securities regulator Legal and regulatory compliance Issuance of prospectus (red herring) List past performance & future prospects Float handled by investment bank •Underwriting basis •Best-effort basis Price band discovery Retail & Institutional options
- 10. FLOTATION PROCESS Registration with securities regulator Legal and regulatory compliance Issuance of prospectus (red herring) List past performance & future prospects Float handled by investment bank •Underwriting basis •Best-effort basis Price band discovery Retail & Institutional options
- 11. The IPO Favoured avenue for the retail investor Intense competition in up-swings – bunched-up Price fluctuation on listing Instances of price rigging Contrasting recent IPOs Indigo v/s Coffee Day
- 12. Buy-backs Go private Boost current share price Return excess capital to shareholders Use in employee compensation programs Reduce operational expenses – dealing with minority shareholders Take advantage of tax considerations
Editor's Notes
- Keynes’s jibe is not entirely misplaced; more than a few punters approach the stockmarkets in the same spirit as the racetrack or the roulette wheel. Yet for all their shortcomings, as Keynes himself acknowledged, stockmarkets offer one singular advantage: they are the best way to bring people with money to invest together with people who can put that investment to productive use.
- The origins of equities Equity, quite simply, means ownership. Equities, therefore, are shares that represent part ownership of a business enterprise. The idea of share ownership goes back to medieval times. It became widespread during the Renaissance, when groups of merchants joined to finance trading expeditions and early bankers took part ownership of businesses to ensure repayment of loans. These early shareholder-owned enterprises, however, were usually temporary ventures established for a limited purpose, such as financing a single voyage by a ship, and were dissolved once their purpose was accomplished. The first shareholder-owned business may have been the Dutch East India Company, which was founded by Dutch merchants in 1602 and issued negotiable share certificates that were readily traded in Amsterdam until the company failed almost two centuries later. By the late 17th century, traders in London coffee houses earned their living dealing in the shares of joint-stock companies. But it was not until the Industrial Revolution made it necessary to raise large amounts of capital to build factories and canals that share trading became widespread. By 2013, the capitalisation of the world’s stockmarkets exceeded $58 trillion after the widespread recovery in share prices since 2008. Table 7.1 gives the total stockmarket capitalisation – the value of all shares listed – in several countries; Table 7.2 shows the value of share turnover in various countries.
- a Includes former Amsterdam, Brussels, Lisbon and Paris stock exchanges. b Includes Copenhagen, Helsinki, Iceland, Stockholm, Tallinn, Riga and Vilnius stock exchanges. Sources: World Federation of Exchanges; London Stock Exchange Group
- Raising capital Raising capital remains the main function of equity markets. But the equity markets are not the only way for firms to raise capital. Before turning to the markets to obtain financing, firms undertake a detailed analysis of alternative methods of meeting their requirements. Loans Loans are the main type of financing available to firms that have not issued securities. Lenders such as banks are accustomed to analysing the business plans and financial condition of small firms, and often lend to companies that would have difficulty raising funds in the financial markets. Bank loans, however, are expensive, and banks can lend only a limited amount to a single borrower. Firms which are able to do so often prefer to diversify their borrowing by selling bonds, securities that entitle the holder to payment of interest and repayment of principal at predetermined times. Bonds (discussed in Chapter 4) have the disadvantage of imposing a fixed repayment obligation, which may be difficult to meet if the firm’s revenue is weak. Some firms can meet part of their financing needs by securitisation (discussed in Chapter 5), the sale of securities backed by assets that will generate income in the future. But some firms lack the sorts of assets that are readily packaged into securities, and others may be too small to make securitisation worthwhile. In many countries, markets for securitised assets have yet to develop. Equity Equity, unlike all the other forms of financing, represents the owners’ investment in the firm. Bankers and bond investors will be more generous if the firm has substantial equity capital, because this ensures that the borrowers, the firm’s owners, have put their own money at risk. The disadvantages of issuing equity are that the firm’s profit must be divided among the shareholders and that managers and directors must give primary consideration to investors’ interest in improved short-term earnings rather than pursuing strategies that show less immediate promise. Balancing act Because each type of financing has advantages and disadvantages, a firm typically raises capital in several different ways. Firms carefully manage the relationship between their borrowing and their equity, known as the debt-to-equity ratio or gearing. There is no ideal debt-to-equity ratio. In general, a ratio below about 0.5 indicates that the firm has borrowed little and may not be taking maximum advantage of its shareholders’ capital. Such a firm is said to be underleveraged. Gearing enables the firm to earn a greater amount of profit for each share of equity. Firms may also find it wise to increase their gearing if there are tax advantages to borrowing or if long-term interest rates are low. But if the debt-to-equity ratio is excessive, the firm is said to be highly geared or overleveraged. It is more vulnerable to financial distress, as it must continue to service its borrowings even if sales and profits are weak. Venture capital Another way of financing a business is with venture capital. Venture capitalists invest in new or young firms in return for equity in the firm. They are not lenders, but are equity investors at a stage at which the firm’s shares do not yet trade on public markets. Unlike most equity investors, venture capitalists typically play an active role in selecting management and overseeing strategy. They normally seek to sell their shares within a few years, usually by taking the firm public and selling their shares on the public equity markets. Venture capital is a well-established form of financing in the United States and the UK. Growth in Continental Europe has been more modest.
- Types of equity There are various different types of equity, each having its own characteristics. Common stock or ordinary shares Common stock, as it is known in the United States, or ordinary shares, according to British terminology, is the most important form of equity investment. An owner of common stock is part owner of the enterprise and is entitled to vote on certain important matters, including the selection of directors. Common stockholders benefit most from improvement in the firm’s business prospects. But they have a claim on the firm’s income and assets only after all creditors and all preferred stockholders receive payment. Some firms have more than one class of common stock, in which case the stock of one class may be entitled to greater voting rights, or to larger dividends, than stock of another class. This is often the case with family-owned firms which sell stock to the public in a way that enables the family to maintain control through its ownership of stock with superior voting rights. Preferred stock Also called preference shares, preferred stock is more akin to bonds than to common stock. Like bonds, preferred stock offers specified payments on specified dates. Preferred stock appeals to issuers because the dividend remains constant for as long as the stock is outstanding, which may be in perpetuity. Some investors favour preferred stock over bonds because the periodic payments are formally considered dividends rather than interest payments, and may therefore offer tax advantages. The issuer is obliged to pay dividends to preferred stockholders before paying dividends to common shareholders. If the preferred stock is cumulative, unpaid dividends may accrue until preferred stockholders have received full payment. In the case of non-cumulative preferred stock, preferred stockholders may be able to impose significant restrictions on the firm in the event of a missed dividend. Convertible preferred stock This may be converted into common stock under certain conditions, usually at a predetermined price or within a predetermined time period. Conversion is always at the owner’s option and cannot be required by the issuer. Convertible preferred stock is similar to convertible bonds Warrants Warrants offer the holder the opportunity to purchase a firm’s common stock during a specified time period in future, at a predetermined price, known as the exercise price or strike price. The tangible value of a warrant is the market price of the stock less the strike price. If the tangible value when the warrants are exercisable is zero or less the warrants have no value, as the stock can be acquired more cheaply in the open market. A firm may sell warrants directly, but more often they are incorporated into other securities, such as preferred stock or bonds. Warrants are created and sold by the firm that issues the underlying stock. In a rights offering, warrants are allotted to existing stockholders in proportion to their current holdings. If all shareholders subscribe to the offering the firm’s total capital will increase, but each stockholder’s proportionate ownership will not change. The stockholder is free not to subscribe to the offering or to pass the rights to others. In the UK, a stockholder chooses not to subscribe by filing a letter of renunciation with the issuer.
- Issuing shares Few businesses begin with freely traded shares. Most are initially owned by an individual, a small group of investors (such as partners or venture capitalists) or an established firm which has created a new subsidiary. In most countries, a firm may not sell shares to the public until it has been in operation for a specified period. Some countries bar firms from selling shares until their business is profitable, a requirement that can make it difficult for young firms to raise capital. Flotation Flotation, also known as an initial public offering (IPO), is the process by which a firm sells its shares to the public. This may occur for a number of reasons. The firm may require additional capital to take advantage of new opportunities. Some of the firm’s original investors, such as venture capitalists, may want it to buy them out so they can put their money to work elsewhere. The firm may also wish to use shares to compensate employees, and a public share listing makes this easier as the value of the shares is freely established in the marketplace. The flotation need not involve all or even the majority of the firm’s shares. Table 7.3 shows that the annual value of IPOs in the United States peaked amid the internet boom of 1999–2000 and has been much smaller since then. At some points, IPO activity is dominated by venture-capital firms, but at other times many offerings are promoted by buy-out firms which have taken a company private, restructured it, and wish to sell it. A growing number of IPOs have occurred in other markets, especially in Asia. Some of the biggest flotations in recent years have involved the privatisation of government-owned enterprises, such as Deutsche Telekom in Germany and PetroChina, a petroleum company, in China. Such large firms are often floated in a series of share issues rather than all at once, because of uncertainty about demand for the shares. Agricultural Bank of China’s IPO, which occurred in Hong Kong and Shanghai in 2010, raised a total of $22 billion in two offerings of about 17% of the company’s shares. Another source of large flotations is the spin-off of parts of existing firms. In such a case, the parent firm bundles certain assets, debt obligations and businesses into the new entity, which initially has the same shareholders as the parent. Among the largest spin-offs in recent years were the 2008 sale of Philip Morris International by Altria Group, valued at more than $100billion, and Banco do Brasil’s $6 billion spin-off of its pensions and insurance business in 2013. A third source of large flotations has been decisions by the owners of privately held companies to shift to public ownership. Examples include the $16 billion IPO of Facebook, a social networking company, in 2012, and the $15.7 billion flotation of General Motors Company, which had been controlled by the creditors of its bankrupt predecessor, General Motors Corporation, in 2010. Private offering Rather than selling its shares to the public, a firm may raise equity through a private offering. Only sophisticated investors, such as money-management firms and wealthy individuals, are normally allowed to purchase shares in a private offering, as disclosures about the risks involved are fewer than in a public offering. Shares purchased in a private offering are common equity, and shareholders are therefore entitled to vote on corporate matters and to receive a dividend, but the shares usually cannot be resold in the public markets for a specified period of time. Secondary offering A secondary offering occurs when a firm whose shares are already traded publicly sells additional shares to the public – called a follow-on offering in the UK – or when one or more investors holding a large proportion of a firm’s shares offers those shares for sale to the public. Firms that already have publicly traded shares may float additional shares to increase their total capital. If this leaves existing shareholders owning smaller proportions of the firm than they owned previously, it is said to dilute their holdings. If a secondary offering involves shares already owned by investors rather than shares newly issued by the company, the proceeds go to the investors whose shares are sold, not to the issuer.
- Private offering Rather than selling its shares to the public, a firm may raise equity through a private offering. Only sophisticated investors, such as money-management firms and wealthy individuals, are normally allowed to purchase shares in a private offering, as disclosures about the risks involved are fewer than in a public offering. Shares purchased in a private offering are common equity, and shareholders are therefore entitled to vote on corporate matters and to receive a dividend, but the shares usually cannot be resold in the public markets for a specified period of time. Secondary offering A secondary offering occurs when a firm whose shares are already traded publicly sells additional shares to the public – called a follow-on offering in the UK – or when one or more investors holding a large proportion of a firm’s shares offers those shares for sale to the public. Firms that already have publicly traded shares may float additional shares to increase their total capital. If this leaves existing shareholders owning smaller proportions of the firm than they owned previously, it is said to dilute their holdings. If a secondary offering involves shares already owned by investors rather than shares newly issued by the company, the proceeds go to the investors whose shares are sold, not to the issuer.
- The flotation process Before issuing shares to the public, a firm must engage accountants to prepare several years of financial statements according to the Generally Accepted Accounting Principles, or GAAP, of the country where it wishes to issue. In many countries, the offering must be registered with the securities regulator before it can be marketed to the public. The regulator does not judge whether the shares represent a sound investment, but only whether the firm has complied with the legal requirements for securities issuance. The firm incorporates the mandatory financial reports into a document known as the listing particulars or prospectus, which is intended to provide prospective investors with detailed information about the firm’s past performance and future prospects. In the United States, a prospectus circulated before completion of the registration period is called a red herring, as its front page bears a red border to highlight the fact that the regulator has not yet approved the issuance of the shares. Different approaches to selling the shares The sale of the shares to investors is normally handled by an investment bank or issuing house. Investment banks do this in three ways. In the case of good-quality issuers, the investment banker usually serves as the underwriter. An underwriter commits its own capital to purchase the shares from the issuer and resell them to the public. It uses its knowledge of the market to decide, subject to the issuer’s approval, how many shares to issue and what price to charge. This is critical: if the price is set too high, the underwriter may be stuck with unsold shares, but if the price is set too low, the issuer will realise less money than it could have. In some cases, the underwriter may sell the shares by tender, simply asking potential investors to bid for shares. If it is unhappy with the price its shares will bring, the issuer can postpone or withdraw the flotation, or find a private buyer rather than selling to the general public. The second method is for an investment bank to distribute the shares on a best-efforts basis. In such a case, the investment bank is not underwriting the shares and has no risk if they fail to sell; rather, it is simply committing to use its best efforts to sell the shares on behalf of the issuer. Any unsold shares will be returned to the issuer. Investors are usually suspicious of a best-efforts flotation as it implies that the investment bank did not have a sufficiently high opinion of the issuer to be willing to underwrite the shares. The third type of flotation is an all-or-none offering. This is a best-efforts offering undertaken on the condition that all shares are sold at the offer price. If some shares remain unsold, the entire offering is cancelled. Firms in the UK may float shares with an offer for sale. This requires establishing a price at which the shares are to be sold, printing the entire prospectus in newspapers and soliciting applications to purchase shares directly from the public. Regulations make direct flotation difficult in many countries. In the United States, a 2012 law increased the number of people who can own shares in certain small firms before those firms must register with the regulator, and allowed them to raise small amounts of equity online by marketing directly to potential investors. IPOs were a minor part of the equity market until the late 1990s, when large numbers of internet-related firms were brought to market. In both 1999 and 2000, IPOs in the United States raised more than $64 billion, more than 12 times the amounts raised a decade earlier. As other countries changed their regulations to make flotation easier, IPOs became more common, and firms that had never reported a profit routinely began selling shares to the public, a practice that was unusual before the mid-1990s. By 2000, however, it became evident that many of the firms that had undertaken IPOs were unlikely ever to make a profit, and some of them failed. Investors grew reluctant to buy new issues, and the number of IPOs fell. The level of activity in North America and Europe has generally been lower since 2000, partly because of economic turmoil in the United States in 2007–09 and recessions and financial crises in much of Europe, but there has been a notable upswing in IPOs by companies based in Asia. After a slow year in 2012, when issuers worldwide raised about $100 billion through IPOs, the number and size of new issues picked up markedly in 2013, as issuers sought to take advantage of stronger share prices in many markets around the world.
- The flotation process Before issuing shares to the public, a firm must engage accountants to prepare several years of financial statements according to the Generally Accepted Accounting Principles, or GAAP, of the country where it wishes to issue. In many countries, the offering must be registered with the securities regulator before it can be marketed to the public. The regulator does not judge whether the shares represent a sound investment, but only whether the firm has complied with the legal requirements for securities issuance. The firm incorporates the mandatory financial reports into a document known as the listing particulars or prospectus, which is intended to provide prospective investors with detailed information about the firm’s past performance and future prospects. In the United States, a prospectus circulated before completion of the registration period is called a red herring, as its front page bears a red border to highlight the fact that the regulator has not yet approved the issuance of the shares. Different approaches to selling the shares The sale of the shares to investors is normally handled by an investment bank or issuing house. Investment banks do this in three ways. In the case of good-quality issuers, the investment banker usually serves as the underwriter. An underwriter commits its own capital to purchase the shares from the issuer and resell them to the public. It uses its knowledge of the market to decide, subject to the issuer’s approval, how many shares to issue and what price to charge. This is critical: if the price is set too high, the underwriter may be stuck with unsold shares, but if the price is set too low, the issuer will realise less money than it could have. In some cases, the underwriter may sell the shares by tender, simply asking potential investors to bid for shares. If it is unhappy with the price its shares will bring, the issuer can postpone or withdraw the flotation, or find a private buyer rather than selling to the general public. The second method is for an investment bank to distribute the shares on a best-efforts basis. In such a case, the investment bank is not underwriting the shares and has no risk if they fail to sell; rather, it is simply committing to use its best efforts to sell the shares on behalf of the issuer. Any unsold shares will be returned to the issuer. Investors are usually suspicious of a best-efforts flotation as it implies that the investment bank did not have a sufficiently high opinion of the issuer to be willing to underwrite the shares. The third type of flotation is an all-or-none offering. This is a best-efforts offering undertaken on the condition that all shares are sold at the offer price. If some shares remain unsold, the entire offering is cancelled. Firms in the UK may float shares with an offer for sale. This requires establishing a price at which the shares are to be sold, printing the entire prospectus in newspapers and soliciting applications to purchase shares directly from the public. Regulations make direct flotation difficult in many countries. In the United States, a 2012 law increased the number of people who can own shares in certain small firms before those firms must register with the regulator, and allowed them to raise small amounts of equity online by marketing directly to potential investors. IPOs were a minor part of the equity market until the late 1990s, when large numbers of internet-related firms were brought to market. In both 1999 and 2000, IPOs in the United States raised more than $64 billion, more than 12 times the amounts raised a decade earlier. As other countries changed their regulations to make flotation easier, IPOs became more common, and firms that had never reported a profit routinely began selling shares to the public, a practice that was unusual before the mid-1990s. By 2000, however, it became evident that many of the firms that had undertaken IPOs were unlikely ever to make a profit, and some of them failed. Investors grew reluctant to buy new issues, and the number of IPOs fell. The level of activity in North America and Europe has generally been lower since 2000, partly because of economic turmoil in the United States in 2007–09 and recessions and financial crises in much of Europe, but there has been a notable upswing in IPOs by companies based in Asia. After a slow year in 2012, when issuers worldwide raised about $100 billion through IPOs, the number and size of new issues picked up markedly in 2013, as issuers sought to take advantage of stronger share prices in many markets around the world.
- Investing in IPOs Investors often compete intensely for shares in new flotations, and this can cause the prices of shares to rise sharply in the first few hours or days after issuance. After this initial rise, however, evidence from the United States indicates that most new issues subsequently trade for some period below the price at which they were initially offered, so an investor can buy them more cheaply than at the time of flotation. Some never regain the prices they reached in the first few days of trading. For this reason, many experts consider it unwise for unsophisticated investors to buy newly floated shares. The US authorities have investigated alleged improprieties by investment banks in connection with IPOs. These investigations have led to claims that some banks gave favoured clients an opportunity to buy new issues at the offer price and then to profit by reselling to less sophisticated investors in the ensuing price run-up. Employees at some investment banks have also been accused of unduly promoting IPOs in which they personally stood to profit by obtaining shares at the offer price and then reselling them at a mark-up. Some investors nonetheless consider IPOs to be attractive investments, as in some cases the shares reach a level of many times the offer price.
- Share repurchases Just as firms may issue new shares, they may also undertake to acquire their own shares from willing sellers, a process known as a repurchase or a buy-back. A repurchase may be undertaken for several reasons: A firm may wish to repurchase all its shares and become a privately owned corporation. A partial share repurchase is often used in an attempt to boost a sagging share price, particularly because it signals to the market that the company’s own managers, who presumably know its prospects best, consider the shares undervalued. A repurchase gives the firm a way to return excess capital to shareholders. Many countries give favourable tax treatment to gains from the sale of securities, known as capital gains. In such a case, taxable shareholders may benefit if capital is returned via a share repurchase rather than through a dividend. Some firms repurchase shares for the purpose of using them in employee compensation programmes. Some repurchase offers are aimed at investors who own only a small number of shares in order to reduce the expense of dealing with shareholders. The attractiveness of repurchase programmes depends heavily on tax considerations. They are infrequently used in countries, notably Germany, which treat the proceeds as regular income rather than as a capital gain. Repurchases have been widely criticised for enabling a firm’s managers, who control the timing of repurchases, to manipulate the share price in ways that increase the value of their stock option grants or bonuses. The issuer holds any repurchased shares as treasury stock, which is not entitled to a vote on corporate matters and does not receive a dividend. However, the firm is free to resell treasury stock or to use it for employee compensation without further shareholder approval. A shareholder’s ownership of the company would be diluted if treasury stock were to be returned to public ownership in future.